What is the revenue recognition principle?

The method you choose to report your company earnings can impact your startup's financial narrative. Accrual accounting, one of the primary methods of keeping financial records, aligns revenue with the expenses that were incurred to generate it (irrespective of the timing of cash transactions). This method provides the most accurate picture of a company's financial performance at any given time.

And central to accrual accounting is the revenue recognition principle.

What is the revenue recognition principle?

The revenue recognition principle is an accounting guideline which dictates that revenue should be recognized and recorded in the period it’s earned and when the revenue is measurable, regardless of when the payment is received. This principle ensures that financial statements provide an accurate and consistent view of a company's earnings during a specific period.

Revenue recognition and the matching principle

The revenue recognition principle, when paired with the expense recognition principle, forms the foundational accounting concept called the "matching principle." This principle basically says that expenses should be recognized and recorded in the same accounting period as the revenues they helped generate, regardless of when the cash transactions occur. This alignment ensures that each reporting period accurately reflects the true costs associated with the revenue earned, providing a clear and complete view of a company’s financial performance. The main benefit of applying the matching principle is that reported profits are neither overstated nor understated, giving stakeholders a reliable basis for evaluating the company's operational success.

Why is the revenue recognition principle important?

Consistently using the revenue recognition principle ensures compliance with accounting standards, helping to create a financially disciplined environment that prioritizes long-term growth over short-term gain. By leveraging this accounting method, startups can also reap benefits like:

• Healthier cash flow management: Applying the revenue recognition principle helps create more predictability around your startup’s monthly recurring revenue (MRR), facilitating more effective budgeting and financial planning.
• Smoother investor relations: Consistent and transparent earnings are a clear, reliable gauge of a company’s financial health and performance — and as such, can help investors or potential investors feel more confident about your company.
• Valuable customer insights: Tracking revenue using this application of revenue recognition, particularly in the case of subscription-based business models, allows you to analyze trends and adjust marketing strategies and/or product offerings based on retention rates and customer behavior.

The 5-step model for revenue recognition

The Financial Accounting Standards Board (FASB) introduced a five-step model for revenue recognition under Generally Accepted Accounting Principles (GAAP). This aims to simplify and standardize this process, promoting consistency and comparability across different industries.

Step one: Identify the contract(s) with a customer

This step goes into what needs to be laid out in the contract when a company enters into an engagement with a customer to deliver goods or services. Under GAAP, the criteria for this contract include approval and commitment by all parties (this could be orally or in writing), a clear and easy-to-understand overview of each party’s rights regarding goods or services, identification of payment terms, commercial substance (i.e., the impact the contract will have on the company’s future cash flow), and probability of collection.

Step two: Identify the performance obligations in the contract

Once the contract is established, the next step is to identify all distinct performance obligations. A performance obligation is a contractual promise on behalf of a company to provide agreed upon goods or services to a customer. It is considered distinct if it meets two main criteria: 1) the customer has to be able to benefit from the good or service on its own or with other readily available resources, and 2) the obligation has to be separately identifiable from other outlined deliverables or obligations in the contract.For example, a contract between a marketing agency signing up for a new SaaS software might include three distinct performance obligations: access to the software, dedicated customer support, and implementation services to support the initial setup.

Step three: Determine the transaction price

The third step involves determining the transaction price, which just refers to the compensation — cash or non-cash — that a company will earn from the customer in exchange for goods or services, per the contract. The transaction price might include fixed amounts, variable amounts, or both, and should also factor in any discounts, upgrades, prorations, or pricing customizations agreed upon by the company and customer during negotiations.

Step four: Allocate the transaction price to the performance obligations in the contract

After determining the transaction price, the next step is to assign a portion of this total price to each distinct performance obligation outlined in the contract. To do this, you’ll want to consider the value of each deliverable on its own and then allocate prices in proportion to each performance obligation’s standalone selling price.

Step five: Recognize revenue as performance obligations are met

The final step in the revenue recognition process is to recognize revenue when (or as) a performance obligation is satisfied, i.e. when the company successfully delivers one of the agreed upon goods or services to the customer. Keep in mind that revenue recognition will differ depending on whether the goods or services being rendered are one-time or continuous.

For single performance obligations, the revenue should be recognized during the accounting period in which the performance obligation is met. For example, if your startup develops a software application and offers a one-time license to use the software, the revenue should be recognized in the accounting period when the customer transacts and receives access to your product.

For continuous performance obligations, like subscription-based businesses, revenue should be recognized over time — i.e., a portion of the revenue should be recognized during each accounting period, versus recognizing the revenue for a full subscription term at the start of a new contract. For example, if you’re a startup that offers a subscription SaaS product and a customer signs up for an annual subscription, you will recognize revenue each month for the portion of the service provided during that month.

Challenges and considerations when applying the revenue recognition principle

Depending on the complexity of your business activities, there can be a few barriers to accurately applying the revenue recognition principle:

• Complex contracts: Navigating revenue recognition in complex contracts can be challenging due to the multiple performance obligations and varied transaction terms that must be clearly identified and separately accounted for.
• Timing and measurement: Determining the exact timing for revenue recognition and accurately measuring how much revenue to recognize can be problematic, especially when dealing with long-term or staggered delivery contracts.
• Changes in contract terms: Any amendments or renegotiations in contract terms during the lifecycle of a contract can complicate revenue recognition, requiring adjustments to previously recognized or deferred revenues.
• Industry-specific issues: Different industries face unique challenges in revenue recognition due to sector-specific practices, such as recognizing revenue at the point of sale in retail or over the contract term in services.
• Regulatory compliance and updates: Keeping abreast of changes in regulatory standards and ensuring compliance can be demanding, as updates may require significant changes to accounting practices and systems.

While each of these challenges comes with its own nuances, there are some simple steps that can make the revenue recognition process more seamless — e.g., working with your team’s project manager to build a calendar with clear deliverable milestones can help ensure that nothing slips through the cracks, or leveraging a contract management software to keep track of important dates, deadlines, and other contract milestones. A robust accounting software can also be a big asset here, helping to automate some of the tasks involved with revenue recognition, like subscription tracking.

Nailing down the revenue recognition principle is invaluable when it comes to the accuracy and reliabiility of your startup’s financial reporting, ensuring that your earnings match up with the delivery of your products or services. While it can be a bit complex, embracing this principle boosts transparency in your reports, helps you make smarter decisions, and allows your startup to remain flexible as it scales.